The financial industry is the largest market in the world. Under intense scrutiny amidst the Financial Crisis of 2008, Western economies such as the UK and US took to heavy regulatory reform and clamped down on speculative behaviour. However, this proved costly for economic growth – producing a wave of unintended consequences that render a repeat of the 2000s all the more likely.
Dodd-Frank Reform
US Law passed in 2010 to curb speculative excesses
The Dodd-Frank Wall Street Reform and Consumer Protection Act, passed in 2010, comprises sections on regulating banks, derivatives trading and capital requirements. The Volcker rule, a key provision within the law, sought to limit risk-taking by restricting banks from actively buying and selling securities – proprietary trading. This re-established a feature of the original Glass-Steagall law, passed in 1933, that separated consumer and investment banking; this provision was partially removed under the Clinton administration of the 1990s. Dodd-Frank contained further financial regulations.
As was the case during the 1930s, the number of small banks quickly declined following the passage of Dodd-Frank. The number of small community banks declined by 20% in the decade following the subprime mortgage crisis across the US as large banks further consolidated their power. This is because these excessive financial regulations have limited the ability of small-medium banks to remain profitable, relying previously on investments deemed “high-risk” by regulators but remaining profitable by the banks themselves.
Under a liberalised economic framework, the market would punish banks engaging in speculative behaviours through insolvency and eventual bankruptcy. Instead of government bureaucrats determining speculative behaviour, banks should engage in cost-benefit analysis to determine the profitability and riskiness of each investment and thus would lend accordingly. However, the Dodd-Frank Act undermined this entirely; pre-emptively determining the riskiness of each investment and restricting banking behaviour, consequently depriving potentially productive start-ups and businesses of vital credit – a misallocation of credit that stifles productive potential growth. The failure of the 1970s leading up to the sub-prime mortgage crisis made the legislation inevitable as the fabric of a free-market banking system slowly adapted to the emergence of a financial safety net that promoted risk and speculation.
Failure of the Great Recession
Unfortunately, the free-market dream of banks acting with prudent risk management doesn’t exist – largely thanks to government and Central Bank policy. Starting in 1974, the Federal Reserve began bailing out medium to large-sized financial institutions facing bankruptcy. Franklin National Bank engaged in speculative investments during the early 1970s – yet, they were bailed out in 1974. The rationale was that its failure could trigger a banking crisis akin to the 1870s and 1930s; the reality was that Franklin National Bank was the 20th largest bank in the US. Little intervention by regulators likely induced brief uncertainty and panic; however, restructuring and bailout created a far more significant problem.
The Federal Reserve continued pushing the problem down the road with further bailouts in the 1980s – incentivising financial institutions to engage in excessive risk. It was a win-win scenario for the banks; if the risky investments paid off, significant returns followed – insolvency resulted in financial assistance and bailouts as financial institutions bought up risky South-American debt that promised high returns with bond yields soaring, a decade of increasing speculation culminated in the Savings & Loans crisis of 1987. Further bailouts followed, inducing more risky speculation and the centralisation of credit power as the investors realised the government and Central Bank would always bail out larger financial institutions.
Dodd-Frank fails to grapple with the underlying causes of the US Financial Crisis. Further centralisation of credit power has succeeded the subprime mortgage crisis as the number of small-medium-sized banks has declined, leading to the certainty of future bailouts. Heavily regulations have undermined the efficient allocation of credit; as large banks primarily lend to solely large firms, SMEs have been deprived of credit over the past decade. North Dakota is the exception; lending to SMEs has averaged over $12,000 over the past decade compared to less than $3,000 across the US. This is because of their decentralised banking system, whose Republican legislature has taken aggressive action to offset the adverse effects of Dodd-Frank with further deregulation following the Financial Crisis. This has prevented the surge of credit centralisation in North Dakota that currently plagues most of the US as the largest financial institutions continue to gain market share under heavy regulatory burdens that disproportionately hurt smaller banks.
Ultimately, the introduction of further financial regulatory burdens following the Financial Crisis has failed to resolve the underlying cause of the subprime mortgage crisis and exacerbated pre-existing trends. Further centralisation of credit power has occurred, depriving SMEs of credit that has stifled innovation and economic growth across the US. As a pose to banks mediating risk through cost-benefit analysis, regulators have already pre-determined thus – undermining the purpose of banks in the first place as a more efficient allocator of credit. Instead, the opposite tack should have followed – breaking up the large financial institutions that only emerged under the financial safety net of the 1970-the 2000s and ensuring no future bailouts as such.
Free Marketeer 